Secrets Of Success: Down among the small-caps, business is brisk

The stock market rally continues to demonstrate its robustness, confounding investors of a more sceptical nature. One of the most notable features of the past six months has been the strong showing and positive sentiment coming from the small-cap and fledgling sectors of the market. You would expect some outperformance by small caps in an end-of-bear-market rally, but the pace and scale of the revival in market activity is impressive. The FTSE Small Cap index has risen by 48 per cent in the past six months, against 22 per cent for the FTSE All-Share index and 18 per cent for the FTSE 100.

Giles Hargreave, a stockbroking friend who runs the Marlborough Special Situations fund, about the best-performing UK small cap fund over the past five years, believes the recovery in small-cap share prices is based on solid foundations. There is plenty of demand for small-cap shares, from institutions underweight in this segment of the market for some time and scrambling to catch up, and from hardened private investors, many of whom seem to have been pouring back into the stock market this summer like junkies after a bad trip.

You need look no further than the booming share prices of brokers who specialise in small-cap shares to see how the ripples of this renewed activity are spreading through the market. The brokers are doing a busy trade in placings, and takeovers and buyouts are much in evidence. Gervais Williams, the small-cap expert at the fund manager Gartmore, says in the fledgling market one in 10 companies will be taken over this year. (The FTSE Fledgling index covers 350 companies who sit just below the All-Share index in terms of market capitalisation.)

The difference between what has been happening this year and the 1999-2000 bubble is that few companies are being offered at ridiculous multiples. Valuations are back to more sensible levels, and in the case of many small-cap stocks, which have been punished for their illiquidity as well as their intrinsic value, the brokers are not finding it difficult to put a compelling buy story together, something not easy on valuation grounds higher up the market capitalisation scale.

If you look at the Fledgling index again, in aggregate the valuations are undemanding. The index trades on a p/e multiple of just under 10, and the average stock trades at 90 per cent of book value, or half the rating of shares in the All-Share index. Gearing is roughly half that of companies higher up the capitalisation scale.

This segment of the market includes a lot of companies that deserve that kind of rating. If you have a terrible business, it is down in the netherworld of the market that you are likely to end your days.

Even so, there are still good companies that have been oversold. In the fallout from the great bubble of three years ago, as usually happens, the good companies were trashed along with the bad, a trend exacerbated because most big institutions are not interested in supporting research into small-cap stocks. Combine that with the traditional liquidity problems associated with small-cap stocks, and it is easy to understand why significant valuation anomalies could exist.

Mr Hargreave, whose day job is managing director of his family broking firm, Hargreave Hale, says it has been possible to find a good number of interesting stocks in the past few months that have simply been sold down too far. He mentions the likes of the retailer Peacock, which was selling on an earnings multiple of 4.0 this year, and is now up to 7.5 times earnings. At the same time, he has done very well out of buying shares in small companies that have interesting but still untested business models, where investors' risk of loss is comfortably offset by the presence of cash in the balance sheet.

In some cases, there is more cash backing per share than the present market price. Two examples that have done well for him are Netstore and Patsystems, companies that were floated at ridiculously high prices in the bubble, but have survived to fight again on what are now undemanding ratings.

The great Ben Graham, father of modern security analysis, who made his name by ferreting out unknown or unloved companies that sold for less than the value of their assets, would have recognised the opportunities on offer in the lower reaches of the market.

Of course, there is risk involved in hunting for minnows. Many of the companies are far from proven, and there are many traps for the unwary, not the least of which is finding (and selling) the shares you want at a price anywhere near the one quoted on the screen. The key thing that has changed is that demand has returned with a vengeance, which has injected liquidity in the market and brought back the panoply of momentum traders and share tipsters always associated with a market that is moving.

Will it all last? Mr Williams thinks it might. Present conditions remind him of 1993, when small-cap stocks also had a fantastic year, rising more than 50 per cent. Mr Hargreave*, whose judgement I also respect, is also encouraged by the strength of the underlying tone in the small cap market. As a broker, he is closer to the market than many, and, unlike some brokers, far from being an inveterate optimist.

While the stock market is clearly still bound on the upside by valuation constraints, that is not the case in the small-cap area. I would not be surprised to see the strength of small-cap stocks continuing for a while. The combination of sensible prices and positive market sentiment looks powerful.

I have done an extended interview with Giles Hargreave for my newsletter, Intelligent Investor, and will send a free pdf version to interested readers.

davisbiz@aol.com